Basel II - Financial definition
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Concise definition of the term Basel II
Basel II refers to the second set of recommendations issued by the Basel Committee in 2004.
Comprehensive definition of the term Basel II
History
Basel II became necessary because the evolution of financial markets over the last 20 years clearly showed that the regulation emanating from the initial Basel accords from 1988 needed to be strengthened in order to be efficient in preventing the risk of serious malfunctions in these markets. The most important of these shortages were:
- «off-balance-sheet» risks were not taken into account
- Insufficient depth in the analysis of complex instruments and operations
- Insufficient differentiation of credit-linked risks
Basel II approach
In response to the aforementioned shortcomings, Basel II
- Provides a more comprehensive and flexible approach to measuring and managing risk, increasing risk sensitivity in the process
- Adds the concept of operational risk as a new charge
- Promotes banks' internal risk management methodologies
- Incorporates supervisory review and market discipline as part of risk assessment
The Basel II recommendations are articulated around three pillars:
- Minimum capital requirements (McDonough ratio)
- Supervisory review
- Market discipline
Pillar 1 - Minimum Capital Requirements
The first pillar is the one which has been expanded the most since Basel I. It creates a more sensitive measurement of a bank's risk-weighted assets and is designed to eliminate the loopholes in the initial Basel Accords which allowed banks to increase their exposure to risk while still formally satisfying minimum capital requirements.
It defines the modalities of the calculation of minimum capital requirements in order to cover:
It defines the modalities of the calculation of minimum capital requirements in order to cover:
- Credit risk
- Market risk
- Operational risk
Pillar 2 - Supervisory review
The second pillar deals with the regulatory response to the first pillar, extending the rights of regulators in bank supervision and dissolution. Thus regulators are entitled to overseeing the internal risk evaluation methodologies applied by a bank and impose changes if deemed appropriate.
It also provides a framework for dealing with a risk category named residual risk and which encompasses all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk, and legal risk.
It also provides a framework for dealing with a risk category named residual risk and which encompasses all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk, and legal risk.
the Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords
Pillar 3 - Market discipline
This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which encourages transparency in financial reporting and allows market participants to gauge the capital adequacy of an institution.